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Chapter 8

Using the BSOP model for equity and

debt valuation

4.1 Equity valuation

The BSOP model can be used to value the equity of a company.

The basic idea is that, because of limited liability, shareholders can walk
away from a company when the debt exceeds the asset value.
However, when the assets exceed the debts, those shareholders will
keep running the business, in order to collect the surplus.

Therefore, the value of shares can be seen as a call option owned by
shareholders – we can use the BSOP model to value such an option,
where:

P a = fair value of the firm’s assets

s = standard deviation of the assets' value

P e = amount owed to lenders

t = time until debt is redeemed

r = risk-free interest rate

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